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Sunday, September 20, 2020
Good Morning and as always it is a pleasure being here. It is another gorgeous late summer day – in fact today and tomorrow are the last two days of summer. Hard to believe this year has gone by so fast. And before I forget – Go Bears!
Today I want to focus on some Myths that exist regarding Commercial Lending. These are based on questions or calls I often get, and people just do not understand that some things are not doable in Commercial Lending. I hope I can clear the air today and help our listeners understand not only what is not doable, but why it is not doable.
The first Myth is that you can finance a commercial property purchase or business purchase with no money down. I will tell you that is almost never true. Although when you go to buy a home you can get away with as little as 3% down using a government program or by getting private mortgage insurance, that option does not exist in commercial lending. The best we can do on a down payment is only 10% down using the Small Business Administration (SBA) 504 and 7A loan programs for owner-occupied commercial properties or business purchases only, and just about all other lenders require at least 20% down and in most cases 25% down or more.
The reason Bank’s require money down is two-fold. First, based on historical data, Borrowers who put real cash into a deal are substantially more likely to be successful and are less likely to walk away from a business or property. Secondly, all lenders have Loan Policies they must follow. Federal Regulators also have guidelines the Banks must follow and are in their loan policies. Those policies require substantial down payments as a best practice and Banks that do not require strong down payments often times have to reserve more capital against those loans, making the loans substantially more expensive to make.
Now I often see customers try to get around this rule. Just last week I received a phone call from someone wanting to buy a business. The business purchase price was $60 million. The seller of the business in question was willing to carry-back 20% of the purchase price or roughly $12 million in a seller note to be paid over-time. However, the Borrower was not willing to put any equity into the deal. They wanted to rely solely on the seller loan as their equity contribution into the deal. Now take a moment to think about that. The buyer was looking to Borrow $48 million without a penny of their own money into the deal. If you were lending them your own money is that something you would be comfortable with? No lender is going to take on that type of risk. If you think about it, how does a lender know what the real value of that business is? The value of the business could have been inflated so that the seller was comfortable carrying back part of the purchase price. Although lender’s will often allow seller notes behind the Bank loan, and it is a great way to reduce exposure and take risk off the table, Bank’s always require equity in from the Borrower. Sometimes a seller note can reduce that equity, but never can it eliminate it.
Another way Borrowers try to get around the rule is by claiming what they are buying is worth more than the loan amount. I often get calls from someone saying I am buying “x” property for $500,000 but I don’t want to put any money down because “x” property is going to appraise for $700,000 and I am getting a deal because I know the seller. Again, this option does not work. The best measure of what something is worth is the purchase price agreed to by two third parties – as you know Randy being an appraiser – so typically when this option is employed the appraisal never comes in near what the buyer thinks the property is worth but comes in at or near the purchase price. Secondly, Banks and regulators are aware clients might try to inflate the property value on purchases, so Bank policies specifically state in purchase transactions the Bank must advance the lesser against cost or appraisal. So even if it appraises higher, the Bank’s advance is going to go against cost instead of purchase price in that instance. So if the Bank typically advances 75% against an investment property purchase and the appraisal comes in higher than the purchase price, the Bank is going to advance that 75% against the property purchase price instead.
Now the only time we can successfully navigate away from a full down payment is if a Borrower has other collateral to put up so that they do not need to rely only on that down payment.
The second big myth we get is buyers wanting to lock in long-term fixed interest rates on their transactions. Although there are a few niche products where long term fixed rates are available like on certain Small Business Loans and some secondary market loans, 95% of all commercial loans are fixed for 5, 7 or 10 years. This is different than the residential market where the federal government backs all of the loans and because of this backing they get sold into the investment market. It is the government backing of residential mortgages that secures borrowers long-term fixed rates. In the commercial lending world, the Banks are holding these loans against their own capital, using their deposits to lend the money. Banks don’t know what their deposits are going to cost them tomorrow, let alone 5, 7 or 10 years from now. Because of that they don’t like to lock interest rates in long-term. Also, Banks want to keep the terms short because how a business or property performs and its value can change over time, and they want a means to get out of the loan or get a better rate if the business or property performance or value changes.
The last big myth is Borrowers not wanting to sign a personal guaranty on their commercial loan. A personal guaranty on a commercial loan is an individual stepping up and agreeing to back the business or investment real estate loan personally. It is required on almost all commercial loans. It is required as part of the Bank and regulator loan policies for just about all commercial loans for any owners of a business or property that typically own 20% or more. The guaranty is taken partially so the Bank could pursue the owners if a default were to occur, but more often than not to give the owners a reason to work with the Bank if an issue comes up. When owners work with Banks, the Banks tend to have a better resolution then when an owner just walks away. Really the only way you can get around having to sign a personal guaranty is if your loan to value is really low (like under 50%), or you have a really strong tenant, or the Bank can mitigate the loan’s risk another way. There are some loan products out there referred to as non-recourse, which “don’t require a personal guaranty”. However, even many non-recourse products have what they call “bad-boy” guarantees that in essence serve as a personal guaranty should the Borrower or Guarantor act inappropriately, so even those loans come with some guaranty risk.
I know I covered a lot today. I would be more than happy to go into more details on any of these topics at any time and I would be more than happy to discuss your specific requests and see if there is a way to get around some rules in a way that makes sense and is practical. Sometimes there are ways to get creative in Commercial Lending, but there are some rules and policies there is no way to overcome. Having to bring equity to the table (without outside collateral), getting shorter-term interest rates (without qualifying for just a few niche products) or getting out of providing a government guaranty, are a few things that are very hard to get around.